Tag: Bailouts

I’ve just read Eugene White’s Bank Underground post on the Baring liquidation in 1890. He is notable in getting the facts of what he calls the “rescue” mostly right. He accurately portrays the “good bank-bad bank” structure and the fact that the partners who owned the original bank bore the losses of the failure. What he doesn’t explain clearly is the degree to which the central bank demanded insurance from the private sector banks before agreeing to extend a credit line that would allow the liquidation of the bad bank to take place slowly.

These facts matter, because a good central banker has to make sure that the incentives faced by those in the financial community are properly aligned. In the case of Barings macroeconomic incentives were aligned by making it clear to the private banks that when a SIFI fails, the private banking sector will be forced to bear the losses of that failure. This brings every bank on board to the agenda of making sure the financial system is safely structured.

In the 19th c. the Bank of England understood that few things could be more destabilizing to the financial system than the expectation that the government or the central bank was willing to bear the losses of a SIFI failure. Thus, the Bank of England protected the financial system from the liquidity consequences of a fire sale due to the SIFI, but was very careful not to take on more than a small fraction (less than 6%) of the credit losses that would be created by the SIFI failure.

This is the comment I posted:

While this is one of the better discussions of the 1890 Barings liquidation, for some reason modern economic historians have a lot of difficulty acknowledging the degree to which moral hazard concerns drove central bank conduct in the 19th c. White writes:

The Barings rescue or “lifeboat” was announced on Saturday November 15, 1890. The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities. A four-year syndicate of banks would ratably share any loss from Barings’ liquidation. The guarantee fund of £17.1 million included all institutions, and some of the largest shares were assigned to banks whose inattentive lending had permitted Barings to swell its portfolio.

Clapham (cited by White), however makes it clear that the way the Bank of England drummed up support for the guarantee fund was by making a very credible threat to let Barings fail. Far from what is implied by the statement “The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities”, the Bank of England point blank refused to provide such an advance until and unless the guarantee fund was funded by private sector banks to protect the central bank from losses, Clapham p. 332-33.

In short, treating the £7.5 million (which is actually the maximum liability supported by the guarantee fund over a period of four years, Clapham p. 336) as a Bank of England advance may be technically correct because of the legal structure of the guarantee fund (which was managed by the Bank), but gets the economics of the situation dead wrong.

19th century and early 20th century British growth could only take place in an environment where central bankers in London were obsessed with the twin problems of aligning incentives and controlling moral hazard. Historians who pretend that anything else was the case are fostering very dangerous behavior in our current economic climate.

Brad DeLong, who is a brilliant economic historian and whose work I greatly respect, has really mistaken his facts with respect to the history of the Bank of England. And in no small part because DeLong is so respected and so deserving of respect, this post is pure siwoti.

DeLong writes: “central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to. During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it.”

DeLong gets the facts precisely backwards. In 19th century crises prior to any breach of the 1844 Act, the Act was suspended by the British government, which promised to indemnify the Bank for legal liability for any breach of the restrictions in the 1844 Act. The text of the 1847 letter was published in the Annual Register and was the model for subsequent letters. It read:

”Her Majesty’s Government have come to the conclusion that the time has arrived when they ought to attempt, by some extraordinary and temporary measure, to restore confidence to the mercantile and manufacturing community; for this purpose they recommend to the Directors of the Bank of England, in the present emergency, to enlarge the amount of their discounts and advances upon approved security, but that in order to retain this operation within reasonable limits, a high rate of interest should be charged. In present circumstances they would suggest, that the rate of interest should not be less than 8 per cent. If this course should lead to any infringement of the existing law, her Majesty’s Government will be prepared to propose to Parliament, on its meeting, a bill of indemnity. ”

In the kabuki show that took place during each of these events, the Bank typically denied that action on the part of the government was necessary. In 1847 it was the mercantile community that depended for existence on the support of the Bank, which sent a delegation to Downing Street to ask that the 1844 Act be suspended (Clapham, II, 208-09). Thus, the Bank most certainly did not act ultra vires. Instead, the terms of its charter were explicitly relaxed by the government each and every time the Bank breached the terms of the 1844 Act.

The relevant part of the 1857 Bill of Indemnity reads:

“the said Governor and Company, and all Persons who have been concerned in such Issues or in doing or advising any such Acts as aforesaid, are hereby indemnified and discharged in respect thereof, and all Indictments and Informations, Actions, Suits, Prosecutions, and Proceedings whatsoever commenced or to be commenced against the said Governor and Company or any Person or Persons in relation to the Acts or Matter aforesaid, or any of them, are hereby discharged and made void.” (See R.H. Inglis Palgrave, Bank Rate and the Money Market, 1903 p. 92)

In short, far from delegating to the central bank the authority to make the decision to take ultra vires actions, the Chancellor of the Exchequer and the Prime Minister were important participants in every single crisis — and they signed off on extraordinary actions by the Bank, before the Bank’s actions were taken.

Indeed, to the degree that the Bank issued notes beyond the constraints of the 1844 Act, the government was paid the profits from the issue of those notes. Effectively this was the quid pro quo for the government’s indemnity of the Bank. (See e.g., George Udny, Letter to the Secretary of State for India dated January 1861 pp. 25-26).

Peter Conti-Brown and Philip Wallach are having a debate that cuts right to the heart of what appears to me to be the most important economic question of the current era: what is the proper role of the central bank?

Conti-Brown takes what I think is a fairly mainstream view of the central bank’s role as lender of last resort: In a crisis, the central bank should intervene to rescue a troubled bank as long as, given Fed support, the bank can over time be restored to solvency. He writes:

in a systemic crisis, the problem of determining whether a specific asset class is sufficiently valuable to justify its temporary exchange for cash isn’t just “murky,” it can be impossible to determine. This is true for two reasons: first, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency. There is essentially no way, in the depth of a crisis, to draw the line meaningfully between solvency and illiquidity. After Lehman, the Fed recognized this and extended loans through 13(3) so quickly on so many different kinds of collateral that we saw an explosion in its 13(3) lending.

The clear implication here is that if there is doubt as to whether a firm is illiquid or insolvent, the Fed should err on the side of supporting the firm.

Wallach responds that if one follows this logic to its end, there appear to be no limits to the Fed’s powers:

If I’m understanding him correctly here, Peter means to put in the Fed’s mouth some version of an infamous 2004 pronouncement of a Bush administration aide: “when we act, we create our own reality.” Amidst the chaos of crisis, it is for the Fed to decide which firms are solvent and which kinds of assets are really valuable as collateral and, whatever they decide, the markets will follow, allowing the central bank to benefit its own balance sheet and the larger financial system through self-fulfilling optimistic prophecy. As they forge this new reality, making the security on loans satisfactory to themselves will be the least of their miracles.

Teasing aside, I think that’s far from crazy, but one can get carried away. It can’t be the case that the Fed is capable of rescuing any institution through this kind of heroic thinking: if a firm is in a downward spiral, and the only collateral it has is rotten, then the Fed does not have the legal authority to funnel money into it.

I think that there are actually three question raised by this exchange: First, what are the Fed’s potential powers; that is, what is it feasible for the Fed to do? Second, what were the Fed’s powers in 2008; or alternatively, what was both legal and feasible for the Fed to do? And, third, what should the Fed have legal authority to do? Conti-Brown and Wallach are debating the second question, but I think it’s important to explore the first question regarding what the Fed can do, before moving on to the second and third questions regarding what the Fed is legally authorized to do.

A little history on the concept of the lender of last resort is useful in exploring the first question. A previous post makes the point that the term lender of “last resort” was initially coined, because the central made the self-fulfilling determination of whether or not a bank was solvent and worthy of support. The fact that the central bank has the alternative of saving a bank, but chooses not to is what defines the power of a lender of “last resort.” From the earlier post:

The term “lender of last resort” has its origins in Francis Baring’s Observationson the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.

In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain [where the concept of lender of last resort was developed].

There is a long list of banks that were deliberately allowed by the Bank of England to fail in Britain, including the Ayr Bank in 1772, and Overend, Gurney, & Co. in 1866. The latter was, second to the Bank of England, the largest bank-like intermediary in England at the time, and its failure triggered a Lehman-like financial crisis — that was, however, followed by only a short, sharp recession of unexceptional depth. Bagehot made it very clear in Lombard Street that he did not believe that the Bank of England had mishandled Overend Gurney. He argued, on the contrary, that it was always a mistake to support a “bad bank.”

In short, just as it is in some cases the job of a court of last appeal to uphold the law in the form of a death sentence, so it is in some cases the job of a central bank to pronounce a death sentence on a bank in order to promote healthy incentives in financial markets. The fact that the bank would still be alive in the absence of the death sentence is as obvious and irrelevant in the case of the lender of last resort as it is in the case of the court of last appeal.

So let’s go back to the original question: What are the potential powers of the Fed? Can it in fact determine “which firms are solvent and which kinds of assets are really valuable as collateral” and expect markets to follow that determination? We have a partial answer to this question: from past experience we know that a central bank can choose not to support a bank in a crisis in which case it is almost certain the bank will fail, or that a central bank can choose to support a bank and with equal certainty carry it through a crisis of limited duration. We also know that sometimes a bank that was saved fails a few years or a decade after it was saved (e.g. City of Glasgow Bank). The British history also indicates that it is possible for a central bank to have a similar effect on assets (see here).

Thus, the fact that ex post the Fed did not lose money on any of the Maiden Lane conduits — or more generally on the bailout — is not evidence that the Fed exercised its lender of last resort role effectively. Instead this fact is simply testimony to powers of a central bank that have been recognized from the earliest days of central banking.

What we don’t know are the limits of a central bank’s ability to “create it own reality.” Can a central bank continue to support banks and assets for a prolonged period of time and still be successful in leading markets? At what point, if ever, does the central bank’s intervention stop being a brilliant act of successful alchemy, and end up looking like fraud?

What makes a lot of people in the financial industry nervous about the current state of central bank intervention (see for example here, here or here) is that they are not sure that the central banks will be able to exit their current policies without causing a crash in financial markets of the sort that none of us has ever seen before. Of course, we are sailing uncharted waters and literally nobody knows the answer. Let’s just hope that Janet Yellen and Mario Draghi are brilliant and creative helmsmen. (Should that be helmspeople?)

In summary, the term lender of “last resort” itself makes it clear that a fundamental aspect of a central bank’s duties is to refuse to support firms such as Lehman. Thus, in my view Conti-Brown, even though he gives a description of a lender of last resort that many modern scholars would agree with, envisions a lender of last resort that is very different from that of Bagehot and 19th century bankers. Whereas Conti-Brown appears to argue that, because the line between solvency and insolvency is so murky in a crisis, if a bank can be saved, it should be saved, Bagehot clearly understood that even though Overend Gurney could have been saved (ch X, ¶ 11), it was correct for the Bank of England to choose not to save it.

This very traditional view of the central bank, as the entity that determines which banks are managed in such a way that they have the right to continue operating, indicates that the Fed’s error in 2008 was not the decision to let Lehman fail, but the failure to prepare the market for that decision beforehand. The Bank of England announced its policy of not supporting bill-brokers such as Overend, Gurney & Co. in 1858, fully eight years before it allowed Overend to fail. This failure was followed by a full century of financial stability. The Federal Reserve, by contrast, never clearly stated what the limits of its lender of last resort policy would be in the decades preceding the 2007-08 crisis. Indeed, the Fed was busy through those decades expanding the expectations that financial institutions had of support from the Fed. Thus, the post-Lehman crisis was decades in the making, and was further aggravated by the inadequate warning signs provided to markets subsequent to the Bear Stearns bailout.

The definition of the proper role of the central bank is probably the most important economic question of our times. We are learning through real-time experimentation what are the consequences of extensive central bank support of the financial system — and whether financial stability is better promoted by a 19th century lender of last resort that very deliberately allows mismanaged banks to fail or by a 21st century lender of last resort that provides much more extensive support to the financial system.

Peter Conti-Brown argues that the Fed could have bailed out Lehman Bros. but chose not to and is using the law as “ex post rationalization” for political action. Philip Wallach argues that the fact that the Fed wasn’t satisfied with Lehman’s collateral means that it could not bail out Lehman.

The underlying question is this: What does the criterion in section 13(3) of the Federal Reserve Act, “secured to the satisfaction of the Federal Reserve Bank” mean? In my view the text itself makes clear that the interpretation of the meaning of the term “secured” has been delegated by Congress to the Federal Reserve Bank in question, subject in theory (although arguably not in practice) to a “reasonableness” standard.

For this reason, I am having difficulty following Conti-Brown’s argument. He writes in a follow up post:

The point is that “satisfaction,” in the midst of a financial crisis, is an entirely discretionary concept. . . . Instead, my argument—and critique—is that Bernanke, Paulson, Geithner, and others made a decision. They exercised the discretion they were entitled to make. They made these decisions knowing that there would have been enormous political fallout if they had bailed out another Wall Street “bank.” And they made it knowing that the legal authority to go in another direction was broad, robust, and entirely left to the discretion of two bodies of decision-makers within the Federal Reserve System. The Fed wasn’t legally obliged to do anything. But nor was it legally prevented from doing something.

I think there is confusion here. The Fed was granted discretion to interpret the meaning of the term “secured” within reasonable bounds. It was not, however, granted discretion to do whatever it thought was necessary in a financial crisis.

Thus, I don’t think it makes sense to call the Fed’s claim that the law prevented it from lending to Lehman an “ex post rationalization.” Conti-Brown appears to be arguing that he knows that the Fed first decided not to bail out Lehman and then later determined that it did not have adequate collateral to “secure” a loan. But it seems much more likely to me that these two determinations were so closely intertwined that they were more or less determined at the same time: that is, it is at least equally likely that the Fed was unwilling to bail out Lehman, because in its discretion it found Lehman’s collateral to be inadequate. Given that the Fed is by law the entity that interprets the meaning of the term “secured” in section 13(3) of the FRA, such a finding by the Fed is close to a final determination on the issue. Thus, far from being an “ex post rationalization,” the Fed’s explanation that a bailout of Lehman was not permitted seems to me simply a description of its decision-making process.

In my view, the fact that the Fed could potentially have exercised its discretion differently is irrelevant. What makes this complicated is, of course, the fact that the Fed turned around found that collateral that was deemed inadequate on September 15 had become adequate a few days later. In short, Conti-Brown appears to be arguing that, if the Fed had authority to bail out AIG et al., then it must have had authority to bail out Lehman.

In my view, this gets the reality of the situation precisely backwards. I think that since the Fed didn’t have the authority to bail out Lehman, it probably didn’t have the authority to bail out AIG. Indeed, the AIG trial has made it clear that regulators believed that an AIG bailout was necessary and that they pushed legal interpretations of Fed authority to their absolute limits. In fact, I suspect you could even get some of the attorneys involved to admit the latter — though they would almost certainly also assure us that no lines were actually crossed. (For an example of this, see the Sept. 21 email from Fed General Counsel Scott Alvarez indicating that a term sheet produced five days after the AIG loan-for-stock bailout was announced had to be changed because the Fed couldn’t own AIG stock.) Whenever you are that close to a boundary, however, it seems very likely that there are lawyers and regulators close to the action and possibly even at a decision making level who believe that lines were in fact crossed — but that they were crossed in order to do what was necessary and in that sense in good faith. On the other hand, I would not expect any such privately held views to come to light until the passage of time has rendered them statements of only historical interest. (And even then only the non-lawyers are likely to speak out.)

In short, it seems to me that a position equally valid to that taken by Conti-Brown is that the Fed didn’t have the authority to bail out Lehman and didn’t have the authority to bail out AIG et al. But the more important point is that the law as drafted deliberately renders this whole discussion moot. The Fed was granted the authority by Congress to make two decisions within a week of each other that would appear to be contradictory. This, in fact, is the essence of what “to the satisfaction of the Fed” means.

IV. Should the Collateralized Money Market be Stabilized or Euthanized?

This is Part IV of a lengthy critique of Bagehot was a Shadow Banker by Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson. The authors of Bagehot was a Shadow Banker equate the shadow banking system with what they call the “market-based credit system” (at 2). To be clear, the authors focus specifically on a market-based short-term credit system or on money markets. In this Part I ask what does it mean to call a credit system “market-based” and whether such a system exists, then I discuss the consequences of moving from an unsecured money market to a collateralized money market, and finally I evaluate the likely effectiveness of the solution proposed by the authors of Bagehot was a Shadow Banker in stabilizing the collateralized money market.

A. Does a “market-based” credit system exist?

The “market-based” credit system is often contrasted with the “bank-based” credit system to distinguish environments where firms raise funds by issuing securities on markets from those where firms raise funds by borrowing from banks.[1] This distinction is clear when we focus on long-term capital markets, such as bond markets where established companies can and do raise money on a regular basis.

When it comes to money markets, however, the line between market-based and bank-based systems cannot be clearly drawn, because the so-called market-based systems rely heavily on guarantees provided by the banking system. The principle instruments used to borrow short-term on markets are commercial paper (the short-term version of a bond) and repurchase agreements, in which the borrower simultaneously sells an asset and agrees to repurchase it at a fixed future date and price, effectively creating a collateralized loan. As was discussed in Part II, as a rule non-financial companies can only borrow on these markets if they have liquidity support from a bank: Because commercial paper typically needs to be rolled over at maturity, almost all non-financial issuers including asset-backed commercial paper conduits must have a liquidity facility, or a bank’s promise to retire the paper if the issuer is unable to do so. Similarly, the most important repo market is backstopped by guarantees provided by the tri-party clearing banks, which bear the credit risk of the borrowers during the day. In short, in the money markets the “market-based” credit system might as well be called the “bank-guaranteed” credit system.

Furthermore, because so-called “market-based” money market instruments require bank guarantees and those guarantees are most likely to be called upon in a crisis, the “market-based credit system” insulates banks from the credit risk of borrowers in normal times, but not in crises. Because such instruments are always designed in normal times when the likelihood that the bank will be obliged to make good on its contingent liability is deemed minimal, these instruments create a form of bank risk that typically carries lower capital requirements than alternatives. For these reasons, the “market-based” short-term credit system is best viewed as a form of bank lending that is designed to minimize capital requirements, and it should be categorized as lying within the “bank-based” credit system.

Another sense in which money market instruments are only nominally “market-based” is that these assets do not trade on secondary markets. Commercial paper is placed and almost never resold before maturity. Repo obligations, similarly, are not traded actively, but held until maturity.[2] By contrast, in 19th c. London, the archetype of a traditional bank-based credit system, there was an active secondary market in the bills that were the primary tool by which central bank policy was implemented.

Repurchase agreements and asset-backed commercial paper (but not commercial paper more generally or 19th c. bills) are both collateralized forms of “market-based” money market instruments. Such collateralized money market instruments can also be considered “market-based” in the sense that they are subject to market risk; that is, if the value of the collateral falls below the value of the debt, the borrower will have to post additional collateral. Market risk is a key concern of the authors of Bagehot was a Shadow Banker, and it is possible that when the authors use the term “market-based credit system” they mean only to refer to collateralized money market instruments that are subject to market risk; if this is the case, in my view, the term, collateralized money market is more clear.

It is not clear whether the authors of Bagehot was a Shadow Banker imagine a world in which so-called “market-based” money market instruments exist without the support of bank guarantees. If so, it should be noted that their solution is tailored to market risk, whereas the bank guarantees are needed to address funding risk. That is, even if there were no market risk and the collateral’s value could not fall, the possibility that the borrower would find itself illiquid and unable to retire or to roll over the debt (for reasons specific to the borrower or to the money market, not to the collateral) would almost certainly mean that funding guarantees were still necessary to support the market.

To summarize, because the finance of longer-term assets requires that these short-term instruments be rolled over, funding risk is always a concern in the so-called “market-based” short-term credit system, and this almost certainly means that this “market-based” credit system cannot exist except when it is backstopped by the banking system. Thus, what is commonly known as the “market based” short-term credit system – including most of the shadow banking system – should properly be understood to lie within the “bank-based” credit system.

The rest of this Part will assume that the authors use the term “market-based” credit system only for the purpose of focusing attention on the market risk inherent in the collateralized portions of the money market. Thus, I will focus on what I will call the collateralized money market.

B. Is transforming credit risk into market risk a good idea?

In the collateralized money market, borrowing is collateralized in order to provide additional security to the lender, and market risk substitutes for a portion of the credit risk that lenders traditionally face. From the borrowers’ point of view less-creditworthy borrowers have access to credit, but this access comes at the expense of raising the costs of borrowing for borrowers, who now have to worry not only about having the resources to pay the debt at maturity, but also about maintaining sufficient collateral to back the loan throughout the life of the loan. Thus, borrowers will elect to use this system if they are not sufficiently creditworthy to borrow unsecured or they have easy access to collateral.

The authors of Bagehot was a Shadow Banker are correct to emphasize that the most important difference between 19th c. British money markets and modern money markets is the role that market risk plays in modern markets. 19th c. money markets focused on managing credit risk exclusively – so much so that Thornton viewed the “science” of credit as the great innovation of the British banking system and a driving force of the economy’s growth.[3] The careful management of credit risk in the 19th c. is illustrated both by the fact that every bill discounted by the Bank of England was guaranteed to be paid in full by at least three different parties, the issuer, the acceptor, and the discounter, and by the fact that the Bank had negligible losses on its discount portfolio, even after a crisis.[4]

The authors of Bagehot was a Shadow Banker treat the growth of market risk and collateralized money market assets as a demand-side phenomenon (at 12). They reference Pozsar’s work which emphasizes that the largest lenders in modern markets, asset managers such as mutual and pension funds, are reluctant to extend unsecured credit to the banks in the form of uninsured deposits and prefer to lend via repos or asset backed commercial paper.[5] (Note that this point should not be overemphasized, because banks are able to raise significant funds, unsecured, by issuing commercial paper.) The second demand-side explanation for the growth of the collateralized money market is the modern asset management practice of using derivatives markets to take on the risks of investing while holding invested funds in monetary assets. Presumably, supply-side effects may also have played a role in the growth of this market, as investment banks found the market both convenient for financing inventories, and possessed of the useful property that in normal times the market was not very sensitive to changes in the credit quality of the borrower.[6]

The authors view this transformation of the money market from one in which credit risk was carefully managed to one where market risk substitutes for credit risk as a benign, if not beneficial, development. There are, however, many concerns that this development should raise.

First are the implications the movement towards collateralized short-term lending may have for the credit quality of our financial institutions. It is possible that this movement reflects declining credit quality among financial institutions that makes it difficult for them to borrow on an unsecured basis. The fact that this change took place alongside the transformation of the investment banking industry from unlimited liability partnerships to limited liability corporations may be an indicator that declining credit quality is an important driving force behind this change. Another potential concern is that the movement to collateralized short-term lending aggravates declining credit quality among financial institutions. Research has shown that repo lending terms are principally determined by the quality of the collateral posted and do not tend to reflect incremental changes in the credit quality of the borrower.[7] For this reason, it is possible that the movement towards collateralized borrowing makes borrowers less concerned about whether or not they are viewed as good quality borrowers.

Second, as was discussed in Part I, early monetary theorists such as Henry Thornton believed that banking contributed to economic growth because it allowed the money supply to expand based on the needs of the economy and that the “science” of credit facilitated this expansion. Collateralized money markets, however, substitute market risk for credit risk, and as techniques for issuing unsecured money market instruments fall into disuse may have the effect of limiting the use of unsecured credit more than the principles of managing credit risk would require. If unsecured credit falls into disuse, the growth of the money supply, and arguably of the economy itself, may be limited by a deficit of collateral. In short, it is not clear that collateralized money market instruments can play the same role in expanding the money supply and in economic growth as that played by unsecured money market instruments.

Finally, repo markets are likely to be even less stable sources of funding for financial institutions than deposits, and thus even more prone to fire sales. Because the realization of market risk in collateralized lending markets can force immediate deleveraging, the availability of funding on repo markets can disappear just as quickly as deposits can be withdrawn – and even more quickly than credit based on unsecured term instruments which can only be withdrawn as the instruments mature. In addition, however, the fact that the collateral on repo markets is funded on a leveraged basis means that small changes in the market prices of assets can result in the need to sell off a large fraction of assets. Because of leverage, repo markets are probably less stable than deposit-based funding.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[8] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

C. Should collateralized money markets be stabilized by protecting leveraged dealers from losses?

The authors of Bagehot was a Shadow Banker recognize that collateralized money market instruments are prone to fire sales and liquidity spirals, but they do not appear to realize that, due to the leverage that is used in repo markets, very small price declines can have very large effects. They argue that a dealer of last resort is all that is needed to stabilize these markets, and that the dealer can do this by putting a price floor on the assets used as collateral. Specifically they write:

just as in Bagehot’s day, the critical infrastructure is an interconnected system of dealers, backstopped by a central bank. Just as in Bagehot’s day, the required backstop may involve commitment to outright purchase of some well‐defined set of prime securities (such as Treasury securities). But it must also involve commitment to accept as collateral a significantly larger set of securities, in order indirectly to put a floor on their price in times of crisis. (at 9).

Two points should be emphasized with respect to this proposal. First, it is important to understand that despite the authors’ focus on the support of asset prices, the key innovation in the “dealer of last resort” proposal is the extension of central bank support to dealers. Secondly, because dealers are very different from banks, the extent of the support provided by the central bank to dealers is likely to be much greater than that provided to banks.

As for the first point, the Federal Reserve has had the ability to accept virtually any security as collateral since 1932 – as long as it was collateral for a loan to a commercial bank.[9] The problem in 2008 was not the nature of the collateral that could be used, but the fact that investment banks didn’t have access to the central bank. Thus, the key innovation of the “dealer of last resort” proposal is not the type of collateral that can be used for a loan, but the fact that dealers – or investment banks – are able to borrow from the central bank using that collateral.

For non-prime assets, the proposal is only that the central bank accept them as collateral, not that it buys them outright. One potential advantage of accepting assets as collateral, rather than buying them outright, is that the central bank may not need to determine their value, but can choose to rely on the valuation of the collateral given by the borrower, because the borrower will be liable for any shortfalls if the collateral is worth less than the loan. In this case, the purpose of accepting an asset as collateral is not to “put a floor” on its price, but to prevent the borrower from being forced to sell it in a fire sale. This is an important distinction to make, because the central bank is not, in fact, intervening in the market pricing mechanism in the way that the phrase “put a floor on the price” implies. Instead, the central bank is making it possible for the borrower to carry the asset at the valuation at which the borrower is willing to buy the asset back in the future. The level of the asset’s market price is affected, but not determined, by this policy.

Under this interpretation of the proposal, the dealer of last resort should not be viewed as supporting the price of assets (as the authors claim in many places), but as supporting the dealer system. While this understanding is not consistent with “putting a floor” on asset prices, it is more consistent with the author’s claim that when the central bank intervenes, the price decline “is not so much halted or reversed as it is contained and allowed to proceed in a more orderly fashion” (at 14). After all, if the goal is to put a floor on the price of the assets, it doesn’t make much sense to claim that these prices will continue to decline in an “orderly fashion.”

Secondly, the function of dealers in supporting market liquidity is very different from the function of banks in honoring deposits and funding guarantees; as a result the nature of a central bank backstop, and indeed the degree of reliance on the central bank is likely to be very different for a dealer of last resort as compared to a lender of last resort. In order to address the problem of liquidity spirals, the authors of Bagehot was a Shadow Banker argue that:

what is clearly needed is some entity that is willing and able to use its own balance sheet to provide the necessary funding. … what we need is a dealer system that offers market liquidity by offering to buy whatever the market is selling. Only in crisis time does the central bank backstop become the market; in normal times, the central bank backstop merely operates to support the market. (at 9).

Because the primary work of a dealer is that of smoothing the market’s movement to a new price, and not of setting a floor on asset prices, it’s far from clear that dealers can ever be expected to the play the role that the authors of Bagehot was a Shadow Banker seem to expect them to play in supporting prices on markets. The traditional constraints on the behavior of a dealer are described by Jack Treynor, the source of the authors’ model of dealer pricing: “the dealer has very limited capital with which to absorb an adverse move in the value of the asset. Furthermore, the dealer’s spread is too modest to compensate him for getting bagged.”[10] Treynor contrasts the role played by a dealer with that of an investor who has the capital to hold positions over a longer term. Thus, a traditional dealer does not “use its own balance sheet to provide the necessary funding” except over very short time horizons. On the other hand, it is true that large-scale proprietary trading and the management of balance sheet exposure to related risks has become a core function of dealers in recent decades. (This is almost certainly related to the role played in the market by limited liability investment banks that have access to vast capital resources the use of which is monitored, not necessarily effectively, by boards of directors.)

Because the traditional function of a dealer is not to support asset prices, however, it seems likely that even dealers engaged in large-scale proprietary trading will let a liquidity spiral run before stepping in to buy in significant quantities – and then they may well allow the price to continue falling as they build up a significant stake in the assets. After all, if sellers want to sell at unreasonably low prices, this will only add to the dealers’ proprietary trading profits in the end.

Indeed, this is what we witnessed in 2008 when Bear Stearns and Lehman were failing: for the most part, the dealers instead of using their balance sheets to support prices on the market sought to avoid being caught holding assets that are falling in value. Thus, one would expect the burden of establishing a price floor for assets to fall heavily on the dealer of last resort or central bank, just as it fell heavily on the Federal Reserve which had to jerry rig facilities such as the Primary Dealer Credit Facility and the Term Securities Lending Facility in order to take on hundreds of billions of dollars of the asset risk of the investment banks in 2008.[11] At the start of October 2008, these two facilities accounted for 60% of the massive expansion of the Federal Reserve’s balance sheet as compared to the previous year. In short, because providing a price floor for assets is not the economic function of a dealer, a central bank that acts as a “dealer” of last resort must be prepared to purchase assets on this scale – and effectively to become the market – in every crisis.

These two points indicate that the value of the dealer of last resort policy is that a troubled dealer can use the assets as collateral to borrow from the central bank, and doesn’t need to sell them at all. The fact that the largest market participants are protected from ever finding themselves forced to sell their assets will undoubtedly be very effective in protecting asset prices from instability due to massive fire sales.

But the proposed policy would also introduces a very troubling asymmetry into our markets. Who has access to central bank’s discount window? Retail investors clearly do not, whereas “dealers,” however they end up being defined, do. The privileged dealers effectively have access to an unlimited balance sheet and can employ leverage without worrying about being forced into a fire sale – and no longer face the traditional constraints that govern dealers’ activities.[12] By contrast, those without this privilege are limited by their capital position in the degree to which they can increase their profits using leverage.[13]

In short, this policy is likely to have the effect of protecting the privileged dealers from losses due to market risk, while other market participants do not receive similar protection. By reducing the costs of leverage to the privileged dealers it is also likely to increase their use of leverage. If the central bank does not monitor the behavior of the privileged dealers vigilantly, it could end up making financial markets more risky, by making the largest financial market participants believe that it is “safe” for them to take on more risk.

These dangers are offset in part by the fact that the dealer of last resort’s actions in a crisis will forestall an immediate collapse and the economic repercussions of such a collapse. And this fact almost certainly justifies the Federal Reserve’s actions in 2008. It is less clear that this fact is enough to justify embracing the “dealer of last resort” proposal as a standing policy.

The reason that the lender of last resort is good policy, whereas the dealer of last resort probably is not good policy, is that banks are different. Their value lies in making possible money markets based on unsecured credit that is extended broadly across the business community and makes modern economic growth possible. The banking system merits the protection of a lender of last resort, because it provides such broad benefits to the community at large, and there is good reason to believe that without a lender of last resort a banking system will collapse entirely.

There is, by contrast, a long history of dealer systems that support trade on financial markets and are not at risk of collapse in the absence of a dealer of last resort. Furthermore, there is little or no evidence that collateralized money market instruments play the same role as uncollateralized money market instruments in economic growth, and thus little or no evidence that collateralized money markets are necessary to the community at large. In fact, the growth of collateralized money markets may undermine traditional unsecured money markets, where a financial institution’s ability to borrow depends on its credit quality, and thereby undermine the market forces that promote high credit quality in the financial industry. For this reason, the collateralized money markets may be destabilizing the financial industry. While the temporary support of these markets in 2008 was well justified, much more evidence of the value of collateralized money markets to the process of economic growth needs to be presented before dealers and investment banks are given privileges similar to those of commercial banks.

[9] Critics complained that “any cat and dog” could be used as collateral at the Fed, after the Federal Reserve Act was amended in 1932. David McKinley, The Discount Rate and Rediscount Policy 97, quoted in David Small and James Clause, The Scope of Monetary Policy Actions Authorized Under the Federal Reserve Act 10 n.22 (FEDS Research Paper 2004-40, 2004).

This is Part III of a lengthy critique of Bagehot was a Shadow Banker, written by Perry Mehrling, Zoltan Pozsar, James Sweeney and Daniel Neilson. In Bagehot was a Shadow Banker, the authors argue that dealers on financial market need a backstop from the central bank and that “central banks have the power, and the responsibility, to support these markets both in times of crisis and in normal times. That support however must be confined strictly to matters of liquidity. Matters of solvency are for other balance sheets with the capital resources to handle them.” This conclusion is mind-boggling to those who know the history of the concept “lender of last resort.” The whole point of a lender of last resort is that this is the entity that makes the determination as to whether a financial institution is solvent or not. Solvent institutions are given liquidity support and allowed to live, and insolvent institutions are not.

The term “lender of last resort” has its origins in Francis Baring’s Observationson the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.

In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain.

For this reason, it is unsurprising that Flandreau and Ugolini find that the Bank of England limited moral hazard “by not lending ‘anonymously’,” but instead by carefully tracking both its exposure to each individual acceptor and discounter, and the degree to which each acceptor and discounter was extending – or overextending – credit to others.[1] This monitoring was accompanied by the rarely-used, but ever-present, threat of refusing liquidity to the acceptor or discounter by refusing to discount its paper.[2] What Flandreau and Ugolini do not appear to realize is that similar policies were in place a full century before the time period that they study.

In 1772, the Bank of England stopped discounting the bills of the Ayr Bank (including accepted bills), because the number of bills the Ayr Bank was circulating was large enough that it was almost certain that the bills were not all “real” — that is, created only through the process of actual commercial trade. At the time a letter was published in the London Chronicle stating:

You will find that the only cause of such bills as are good at bottom being refused by private bankers in London, is because the Bank of England will not discount them, and on that account such bankers cannot turn them into cash till due, be their necessity ever so great. For this and other obvious reasons, you will find it impossible to carry on your business as a banking company independent of the Bank of England, that being the great source of the British funds, and credit without whose countenance and occasional aid, no banker, nor merchant even in London can do business with safety and profit. (Sept. 15-17, 1772)

The author of this letter makes it clear that a bank was solvent because the Bank of England stood behind it, and was insolvent if the Bank did not. In short, after the failure of the Ayr Bank contemporary bankers understood that solvency was not an exogenous state, but for each bank depended upon the on-going support of the Bank of England.

In 1802, thirty years after the Ayr Bank collapse, Henry Thornton explained that one of the fundamental roles played by the Bank of England was to limit the amount of credit available to both London banks and country banks.

While the transactions of the surrounding traders are thus subject to the view of the country banks, those of the country banks themselves come under the eye of their respective correspondents, the London bankers; and, in some measure, likewise, of the Bank of England. The Bank of England restricts, according to its discretion, the credit given to the London banker. Thus a system of checks is established, which, though certainly very imperfect, answers many important purposes, and, in particular, opposes many impediments to wild speculation. (at 176)

Thornton adds:

There seems to be a medium at which a public bank should aim in granting aid to inferior establishments, and which it must often find very difficult to be observed. The relief should neither be so prompt and liberal as to exempt those who misconduct their business from all the natural consequences of their fault, nor so scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or even ruinous may be their state. (at 188).

Thus, Thornton focuses attention on the key policy question faced by the Bank of England: When to withdraw its support from a bank or bill broker that is undermining the quality of origination practices in the market, despite the possibility that the decision could have an adverse effect on the broader market. This illustrates that the Bank of England’s decision in 1866 not to support Overend, Gurney & Co. was made in the context of a long history of similar decisions, which had as their purpose promoting the quality of the London money market.

The authors of Bagehot was a Shadow Banker view the solvency of a bank as a state that exists independent of the central bank, and they view government bailouts to protect bank solvency as a necessary corollary to lender of last resort activities “in any real world crisis.” They explain:

the maintained assumption of the present paper that the financial crisis is entirely a matter of liquidity and not at all a matter of solvency. Under this strong (and admittedly unrealistic) assumption, no additional capital resources are needed to address the crisis because there are no fundamental losses to be absorbed, only temporary price distortions to be capped. In any real world crisis, of course, there are both liquidity and solvency elements at play, so liquidity backstop is insufficient. Just so, in the US crisis, there was the Treasury standing in the wings to provide capital as needed (e.g. TARP). In this paper we have abstracted from such matters in order to draw attention to the liquidity dimension, which remains largely unappreciated. (At 14-15).

Recall, however, that, as was discussed in Part II, careful analysis of the data by economic historians demonstrates that: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.”[3] Thus, in 19th c. England the assumption that a crisis was entirely a matter of liquidity was not an unrealistic assumption at all, since the owners of the bank were personally liable for the circulation of bad debt. And, in practice, all losses were borne by the bankers.

Because the 19th British financial crises were true liquidity crises, the banks from which the Bank of England withdrew support could have continued in business certainly over the short-term and possibly for years in the absence of the denial of liquidity by the Bank of England. For this reason, in 19th c. Britain the lender of last resort’s determination that a bank was not worthy of its support was the direct cause of the bank’s failure. In short, the term “lender of last resort” refers to the central bank’s role of protecting the financial system by denying liquidity to those firms that don’t meet the standards of the central bank.

Bagehot’s prescription for the conduct of a central bank in a crisis is usually framed affirmatively: A central bank must lend freely at high rates on all good collateral. In the 19th c., however, “good” collateral was determined principally by the quality of the acceptance and of the discounter. Thus, Bagehot understood his prescription to be entirely consistent with the Bank’s rejection of paper on which one of the required guarantees was given by Overend, Gurney & Co. And Bagehot’s prescription is also entirely consistent with the disciplinary role played by the lender of last resort in denying liquidity to firms that are so badly run that they can’t give good security as a discounter on their collateral, or in other words be trusted to honor their obligations.

When one understands that the proper exercise of the power of the lender of last resort includes not only supporting the financial system through liquidity crises, but also the careful culling of financial firms to protect the monetary system from badly run firms and the circulation of poor quality assets in the money supply, one realizes that more attention should be paid in the modern literature to the dangers of using liquidity support to keep poorly run firms alive. Instead of assuming, as the authors of Bagehot was a Shadow Banker do, that liquidity crises are always accompanied by solvency crises that must be addressed by government bailouts, it is important to realize that the pre-eminent model of a lender of last resort developed in an environment where there were no bailouts.

Therefore, it seems likely that need for bailouts that is common to so many recent crises may reflect the failure on the part of the central banks to protect the money supply by refusing liquidity support to those firms which are so poorly managed that they are introducing bad assets into the money supply. Indeed, Bagehot warned explicitly that government support of a “bad bank” can have extremely adverse effects on the financial system, because such support “is the surest mode of preventing the establishment of a future good bank.”[4]

This analysis of the term “lender of last resort” allows us to reevaluate the authors’ call for the central bank to act as a “dealer of last resort,” whose job is to put a floor on the price not only of prime securities, but also of non-prime securities by accepting the latter as collateral. But just as the lender of last resort has the duty of determining which banks are well enough managed to merit liquidity support, so the dealer of last resort would have the duty of determining which assets are of a quality that merits price support. Note that this is a determination of asset quality, and thus broad categories of acceptable assets cannot substitute for a review of the bank-specific origination and servicing practices that will determine the true quality of the asset. In short, asking the central bank to act as a “dealer of last resort” is asking it – in the midst of a crisis – to review the underwriting of the loans created by the banking system.

One way to avoid this problem is for the central bank to limit the class of assets on which it lends to those assets that are of high quality, and thus easy to price. But that, of course, is precisely what a traditional lender of last resort does – and it is precisely this protection that the proposed “dealer of last resort” seeks to eliminate. Another way to avoid this problem is to monitor the banks themselves and require that they provide a guarantee of the value of any assets that are aggregated by the bank to be used as collateral for a loan from the central bank. Once again, however, this is a very traditional means by which lenders of last resort have long expanded their lending quickly to the most trusted banks in crises.[5] Perhaps the authors in their proposal for a dealer of last resort seek to expand this ability for banks to package and value their own collateral so that it is more generally available. If so, the problem of moral hazard that is created by this system needs to be addressed, since one would expect the weakest banks to use such a lending facility to gamble for redemption.

My reading of the authors’ proposal for a dealer of last resort, however, is that the authors assume that the central bank has the ability to determine on an asset-by-asset basis the appropriate level for price support. Thus, the authors seem to believe that the central bank will be able to intuit the correct level of price support for the non-prime assets of the banking system without re-underwriting the loans to distinguish which are likely to be performing in the future and which are not. It would be helpful if the authors explained the mechanism by which the central bank is to perform the pricing aspect of its role as dealer of last resort.

This is Part II of a lengthy critique of the paper, Bagehot was a Shadow Banker. First, this Part explains a few of the means by which modern banks address the funding risk inherent in the shadow banking system by providing services that are very similar to acceptances. Then, the maturity of the assets funded on 19th c. and modern markets is discussed along with the consequences of the fact that capital assets are financed on modern markets, creating market risk, in addition to funding risk. Finally, the likelihood that the credit quality of 19th c. money market assets was significantly greater than that of modern assets is explored.

A. Modern equivalents of 19th c. acceptances are common in the modern shadow banking system

The paper correctly explains that an “acceptance,” or the guarantee of payment by a London firm whose acceptance made the bill eligible for discount at the Bank or England, was what made a bill liquid or tradable on London money markets. (Note, however, that it was not unusual for bills to circulate locally without a London acceptance.[1]) The paper makes the rather odd claim, however, that “the closest thing we have to the institution of ‘acceptance’ is the credit default swap” (at 6). On the contrary, the modern shadow banking system is replete with a wide variety of bank guarantees that make otherwise illiquid assets liquid.

The commercial paper market, a cornerstone of the shadow banking system, has always relied on “backup lines of credit” or “liquidity facilities” provided by banks to make it possible for non-financial issuers – and asset-backed commercial paper conduits – to market their commercial paper. These facilities mean that, even if a firm (or conduit) is facing liquidity difficulties when the commercial paper matures, the bank guarantees that the commercial paper will be retired at maturity.[2] In theory, these facilities were designed to address only liquidity problems and did not enhance the credit quality of commercial paper issues; however, regulatory capital requirements made the provision of credit facilities much more costly for banks than the provision of liquidity facilities and, as a result, liquidity facilities were structured to provide credit enhancement along with a liquidity backstop.[3] Just as an acceptance made 19th c. bills marketable in London, so the backup facilities provided by banks to commercial paper conduits make commercial paper marketable in modern markets.[4]

The other cornerstone of the shadow banking system is the repurchase agreement, or repo, market. The most important repo market is the tri-party repo market and this too is anchored by bank guarantees of liquidity. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day (to give the borrowers access to their assets during the day), the two tri-party clearing banks, J.P. Morgan Chase and Bank of New York Mellon, extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[5] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[6] Here, we find that the liquidity of a key shadow banking market is created by bank guarantees, similar to the reliance of the 19th c. London money market on acceptances.

In short, both the commercial paper and repo markets derive their liquidity from bank guarantees. These guarantees seem to be the closest analogs to the acceptances issued by 19th c. London banks. Let us evaluate, however, the claim that a credit default swap is also an analog of an acceptance.

The most important difference between a credit default swap (CDS) and an acceptance is that combining a CDS on mortgage backed securities with mortgage backed securities, for example manufacturing a collateralized debt obligation or CDO, does not produce a liquid asset. (This is true of the backup facilities provided to commercial paper issuers too.) The additional protection may have made the aggregate product marketable, in the sense that the product could be placed once with an investor, but it did not make it liquid in the sense that it created an asset that was traded actively on a market or circulated from hand to hand as a form currency.

Another important difference is basis risk. Unlike acceptances and the guarantees provided to commercial paper issues or to tri-party repo unwinds, a CDS is not related to a particular debt obligation. As the authors of Bagehot was a Shadow Banker note, because a CDS does not guarantee payment of a particular debt, the payment received on a CDS will not necessarily be sufficient to compensate for the amount lost on the unpaid debt. This is basis risk: the risk that the hedging instrument is not a good match for the hedged instrument.

As I understand it, however, when comparing a CDS to an acceptance the authors’ principle claim is that an acceptance converted a non-prime asset, the bill, to a prime asset, the accepted bill, just as a CDS (together with an interest rate swap (IRS) and foreign exchange swap, if needed) converts a risky long-term asset into a “risk-free” prime bill or short-term asset. Thus, the point is that both an acceptance and a CDS (plus IRS) can be used to convert non-prime assets into prime short-term assets. (In my view, bank backup facilities provided to commercial paper and repo markets can play the same role as acceptances in converting non-prime credit risks into prime credit risks, but that was addressed above.)

The nature of the non-prime, risky assets being funded on the money markets in the 19th c. and in modern markets differs in two important respects. First, the risky non-prime assets in modern markets are long-term assets, and as such carry very different risks than the short-term assets funded in the 19th c. Second, the credit quality of the non-prime assets in the two markets is not necessarily comparable.

B. Maturity of assets funded on the money market

The authors of Bagehot was a Shadow Banker define shadow banking as “money market funding of capital market lending” and describe it as “the centrally important channel of credit for our times” (at 2). Capital market lending generally refers to lending with a maturity in excess of one year, and contrasts with lending on money markets for terms of one year or less. (They also describe shadow banking at great length as a “market based credit system.” The question of whether a market based credit system has ever existed will be discussed in Part IV.) The authors do not attempt to show that money market funding of capital market lending took place on a significant scale in Bagehot’s time.

Instead the authors claim that the bill brokers of Bagehot’s day were comparable to money market dealers of the modern era, acknowledging that the market at issue in the 19th c. was a market in short-term private debt (at 4-5). In one sense, I agree with the authors: as argued in Part I, bill brokers were the shadow banks of mid-19th c. England. But it is important to note that the bill brokers’ activities do not meet the authors’ definition of shadow banking, because the funding of capital market lending was a not a legitimate focus of their activities.[7] The business of the bill brokers and of the bankers was the funding of money market instruments that were issued by businesses throughout Britain and functioned as a form of working capital. These money market instruments were short-term and did not involve lending on capital markets.

In contrast, the fact that long-term assets are funded short term by the modern shadow banking system means that modern shadow banking is not “a bill funding market, not so different from Bagehot’s,” but a capital asset funding market. It is for this reason that “mere guarantee of eventual par payment at maturity doesn’t do much good” since “so many promised payments lie in the distant future” and the only option for a lender in a liquidity crisis is to sell the asset or use it as collateral to borrow. Thus, the need for market liquidity is generated by the fact that long-term assets are being funded.

Although the authors imply that market liquidity and funding liquidity – or guarantees of payment in the event of default such as acceptances, backup credit lines, and tri-party clearing bank guarantees – are substitutes (at 7), in fact, modern markets require market liquidity in addition to funding liquidity. In short, the reason that modern markets require a different form of support from 19th c. markets is that by funding long term assets they have characteristics that mean that they are very different from – and much less safe than – 19th c. markets.

Funding long-term assets with short-term liabilities creates funding risk, that is, the risk that you can’t pay the maturing paper by rolling it over into new short-term debt, and relies on bank guarantees in the form of liquidity facilities or tri-party clearing bank guarantees to address this risk. Funding long-term assets with short-term liabilities also creates market risk, the danger that the value of the assets drops significantly below the value of the short-term liabilities before they are refinanced. CDS and IRS are designed to address market risk, but cannot address funding risk. The latter is addressed by the liquidity guarantees provided by banks that are common in the shadow banking system.

Where there is market risk, that risk can be exacerbated when a borrower whose assets have fallen in value is forced to sell assets to get the cash to make up the difference between the value of the collateral and the debt. The sale of assets can drive the price of the assets down further worsening the borrower’s position and forcing additional sales. This has been termed a “liquidity spiral” (though I prefer Richard Bookstaber’s phrase “riding the leverage cycle to hell”).

The authors argue that in order to prevent such liquidity spirals the central bank should act as a “dealer of last resort.” This role requires two changes to the traditional lender of last resort role: first, the central bank should purchase prime securities outright, and, second, it should accept as collateral non-prime securities in order “to put a floor on their price in times of crisis” (at 9). While it is trivially true that an omniscient central bank which knows the “true” value of the assets and the swaps could indeed put a floor on prices in times of crisis, the real question is whether a less-informed real-world central bank can effectively play the role of dealer of last resort.

C. The credit quality of 19th c. assets as compared to modern assets

Another important characteristic almost certainly differentiates 19th c. money market assets from those of modern markets: the personal liability of the issuers and the guarantors. The authors of Bagehot was a Shadow Banker note that “sloppy, or even fraudulent, underwriting” contributed to the severity of the 2008 crisis (at 13 n.3). By contrast in 19th c. Britain, issuers and bankers faced unlimited liability – or capital calls if they were stockholders – on their obligations. Because of the personal stake that the bankers and the owners of banks had in the success of their business, the general credit quality of both assets and acceptances in 19th c. Britain was almost certainly higher than that of the underlying assets or CDS of modern markets. After careful analysis of the data economic historians have concluded: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.”[8]

Thus, another important distinction between a CDS and an acceptance is the fact that a CDS is issued by a modern corporation whereas an acceptance was issued by either an unincorporated firm or a 19th c. British joint stock firm. A debt incurred in the normal course of business by a modern corporation cannot result in a personal claim against a banker or bank shareholder even in bankruptcy. By contrast, an unpaid debt incurred by a 19th c. British joint stock bank was likely in bankruptcy to result in a capital call on the bank’s shareholders. Because joint stock investors in 19th c. Britain typically paid only a fraction of the par value of the shares, the corporation – or in the case of bankruptcy the liquidator – retained the right to call the remaining value of the shares until par was fully paid up. Thus, when Overend failed in 1866, the joint shareholders were required to pay to the liquidators 50% of par, more than their initial investment of 30%, and, as a result, the creditors were finally paid in full.[9] Of course, for unincorporated banks, all bankers were personally liable for the debts of the bank.

Needless to say, in 19th c. Britain one of the reasons for confidence in the guarantees provided by the banking system was the visible personal wealth of the bankers themselves and the knowledge that this wealth was at stake.[10]

Not only were the bank guarantees in 19th c. Britain of higher credit quality than those issued by modern corporations, but the underlying assets were most likely of higher credit quality too. While mortgages and other forms of consumer credit – often originated using faulty procedures – are an important raw material for modern shadow banking, in 19th c. Britain the credit issued was strictly commercial, and it was only put into general circulation when a local bank or London middleman guaranteed the debt through endorsement or acceptance, usually on the basis of personal knowledge of the issuer. As a result of this system, backed by multiple personal guarantees, the assets circulating in 19th c. British money markets were of extremely high credit quality.

Bagehot, when describing the optimal lender of last resort policy of discounting all good securities, describes the 19th c. credit environment: “No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.” In fact, because of Overend’s “bad business,” Bagehot clearly approved of the Bank of England’s decision not to support the bill broker, despite the fact that its failure caused a massive liquidity crisis. (Lombard Street VII.37, VIII.12, X.10-11).

Overall Bagehot was a Shadow Banker fails to recognize that funding risk is as important to modern markets as market risk. For this reason, bank guarantees of payment, the equivalent of acceptances, are relied on in the modern shadow banking system, just as they were in the 19th c. Modern money markets also face market risk because they finance capital, not just money market, assets. It is market risk that the “dealer of last resort” purports to address, by placing the burden on the central bank of determining the correct price floor for non-prime assets. This determination is likely to be complicated by the fact that flaws in modern origination processes together with a paucity of personal guarantees make it possible for low quality assets to end up backing the money supply.

[4] In addition to liquidity and credit facilities, letters of credit have long played a role in commercial paper markets. The standby letter of credit is a guarantee made by a bank to retire maturing debt if the issuer cannot. It has been used for decades to enable firms, whose stand-alone credit rating is not high enough for them to issue commercial paper, to “rent” the credit rating of the bank. Thomas Hahn, Commercial Paper, 79 Fed. Res. Bank of Richmond Econ. Quarterly 45, 58 (Spring 1993). In addition, the letter of credit is a traditional banking instrument, still in use today, that promises to honor any bill drawn in conformance with the letter of credit. Typically goods have been shipped to the party whose debt is guaranteed by the bank, and the shipper will be paid as long as evidence of the shipment and of the debt are appropriately documented. The letter of credit remains an important means of financing international trade.

[6] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[7] Indeed, Overend, Gurney and Co. failed in part because, instead of recognizing losses on bad bills, it converted them (due to inadequate management and less-than-honest employees) into long-term investments in, for example, steamships that ended up causing the losses that took the firm down, despite its robust bill-broking business. W.T.C. King, History of the London Discount Market 247-51 (1972).